Monitoring agency conflicts: use of accounting and direct supervision

Abstract

Purpose Agency theory predicts that agents tend to have more information regarding their own talents and efforts than their principals. This information asymmetry enables chief executive officers (CEOs) to “shirk” or engage in actions that benefit themselves at the expense of shareholders. To circumvent this adverse outcome, firms engage in monitoring efforts. One method is monitoring through high-quality accounting information, which can alleviate agency conflicts by reducing information asymmetry. Direct observation of employees’ performance is another monitoring method. This paper examines whether low accounting quality will increase a board’s tendency to use direct observation to alleviate agency conflicts between managers and shareholders. Design/methodology/approach Monitoring through accounting entails evaluating CEO performance on financial performance targets; monitoring through direct observation involves evaluating CEO performance subjectively. This study uses (1) firms utilizing Big Four auditors, abnormal accruals and earnings’ ability to predict future cash flows as proxies for accounting quality and (2) discretionary bonuses paid to CEOs as an indirect measure for a board's direct observation. Findings We find that a board is prone to employ direct observation to reduce agency conflicts that low accounting quality exacerbates. Research limitations/implications Because we obtain CEO compensation data from large public firms, findings in this study might be limited to large firms. Practical implications The findings in this study can be applied to other areas involving agency conflicts. For example, future research can examine a board's use of direct observation to determine the promotion or dismissal of executives if their firm has low accounting quality. Originality/value Our study shows that public firms can still utilize direct observation to mitigate agency conflicts that low-accounting quality aggravates, even though monitoring through accounting is often viewed as a more efficient monitoring mechanism in public firms.